October 2012
Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
In recent years, increasing numbers of older homeowners have found themselves short of cash in retirement. As a result, reverse mortgages have grown in popularity. Reverse mortgages allow homeowners to tap their home equity in stages as cash is needed for home maintenance, property taxes, travel, health care, and other spending needs. Thus, reverse mortgages can provide a “small steps” approach to positive retirement cash flow. Obtaining a reverse mortgage itself, however, is a big step due to the costs and complexity involved.
Reverse mortgages are, quite simply, a loan in reverse. A reverse mortgage is designed for homeowners age 62+ who have built equity in their homes. It is called a reverse mortgage because the lender pays the homeowner instead of the homeowner paying the lender. The income from the reverse mortgage helps homeowners continue to live in their homes. The money is tax-free and can be used for any purpose.
Reverse mortgages are different than conventional mortgages in several important ways. First, the homeowner(s) must live in the home as a main residence. Unlike conventional mortgages, there are no income requirements. The homeowner does not have to make monthly payments and the homeowner can get their reverse mortgage payments as a lump sum, a line of credit, in fixed monthly payments, or a combination of these. However, when the last borrower moves out of the home or dies, the loan becomes due.
There are two types of reverse mortgages. The first and most common is the Home Equity Conversion Mortgage (HECM) offered through the US Department of Housing and Urban Development (HUD) and the Federal Housing Administration (FHA) for lower to medium value homes. The second type is proprietary reverse mortgages offered through banks and credit unions and designed for people with high value homes.
People who get a reverse mortgage have to pay closing costs the same as borrowers do for traditional forward mortgages. HECM borrowers – those getting a reverse mortgage through HUD—also pay a mortgage insurance premium that protects their stream of payments in the event of an insolvent lender. Most of these upfront costs are regulated and limited in order to protect consumers.
Like any type of loan, there are advantages and disadvantages. On the plus side, reverse mortgages ensure that the owner or the heirs of the owner will never owe more than the value of the home, even if the value of the home goes down. Also, heirs can choose to keep the home if they pay off the full loan balance. With a reverse mortgage, homeowners continue to own their home and can stay in their home. Reverse mortgage payments can be paid to the homeowner in various formats and these formats may be able to be changed if needed.
There are also some downsides or disadvantages to getting a reverse mortgages. There are closing costs and servicing fees that vary with the type of loan and the lender. If closing costs are financed into the loan, this will add to the total cost. Also, because a reverse mortgage taps equity in a home, a large part of the equity can be used up, leaving less for heirs. The loans are complex and may be difficult for some borrowers to understand.
Since reverse mortgages are designed to help people stay in their homes, repayment may be required if a homeowner is in assisted living or a nursing facility for more than a year. Also, the owner is still responsible for property taxes, insurance, and maintenance on the home and can be foreclosed on if these are not paid.
A reverse mortgage can seem complicated so it is very important to get information before entering into this transaction. Anyone who obtains a reverse mortgage is required to have a financial counseling session with a HUD certified housing counselor. There are also good online resources such as www.aarp.org/revmort.
Financial advisors often advise using reverse mortgages as a “last resort” due to their cost and complexity. The longer an older homeowner waits to take out a reverse mortgage (e.g., age 75 versus age 62), the fewer years there will be for interest to accrue and the larger the monthly payment will be for a specific loan amount.